CDT Money: The Numbers Game

Last week’s key data release signaled continued weakness for China’s manufacturing sector, with HSBC’s preliminary purchasing managers index (PMI) shrinking for an eighth straight month in June. Reuters reports that the 48.1 reading – anything below 50 suggests a contraction – is the lowest in seven months and matches a similar streak during the global financial crisis of 2008 and 2009. Input and output prices plunged to their lowest level in two years, writes The New York Times. The most troubling figure, export orders, slipped to its lowest level since March 2009.

“There should be [another] cut in interest rates and in the bank-reserve ratio in July,” said Sheng Hongqing, senior economist at China Everbright Bank. “The export situation is very difficult.” Other economists were also anticipating more monetary policy moves ahead. “The government hasn’t done enough in terms of policy easing,” said Wei Yao, China economist at Société Générale.

A Reuters piece out Monday asserts that no bottom is in sight as China looks increasingly likely to miss its 2012 growth target. But as bearish as recent data appear, could the real situation on the ground actually be worse? In a New York Times piece over the weekend, Keith Bradsher points out that while doubts have persisted for years about the accuracy of Chinese economic data, this is the first time in several decades that a slowdown has coincided with a leadership change at the top of a Communist Party regime that has long-relied on economic growth for its legitimacy and social stability. As a result, local and regional officials with an eye toward promotion may be fudging the numbers:

Record-setting mountains of excess coal have accumulated at the country’s biggest storage areas because power plants are burning less coal in the face of tumbling electricity demand. But local and provincial government officials have forced plant managers not to report to Beijing the full extent of the slowdown, power sector executives said.

Electricity production and consumption have been considered a telltale sign of a wide variety of economic activity. They are widely viewed by foreign investors and even some Chinese officials as the gold standard for measuring what is really happening in the country’s economy, because the gathering and reporting of data in China is not considered as reliable as it is in many countries.

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“The government officials don’t want to see the negative,” so they tell power managers to report usage declines as zero change, said a chief executive in the power sector.

Another top corporate executive in China with access to electricity grid data from two provinces in east-central China that are centers of heavy industry, Shandong and Jiangsu, said that electricity consumption in both provinces had dropped more than 10 percent in May from a year earlier. Electricity consumption has also fallen in parts of western China. Yet, the economist with ties to the statistical agency said that cities and provinces across the country had reported flat or only slightly rising electricity consumption.

Accusations of financial fraud weren’t only reserved for Chinese public officials last week, as one of China’s largest property developers came under fire in a scathing research report rife with allegations of accounting irregularities, bribery and insolvency. Short seller Citron Research published a 57-page report on Thursday about Evergrande Real Estate Group, a Hong Kong-listed company whose property assets have grown 23x since 2006. The report calls out “at least 6 accounting shenanigans” used to hide an actual equity value well less than zero. From the report:

Over the past 5 years, Evergrande has executed an untoward program of bribes aimed at local government officials in order to build its raw land industry. To finance growing cash flow shortfalls related to these bribes, subsequent land purchases, and related real estate construction activities, Evergrande has employed a complex web of Ponzi-style financing schemes. These schemes are characterized by a reliance upon perpetually growing pre-sales, off-balance sheet partnerships and IRR guarantees to third parties.

Evergrande’s business model is unsustainable, and is showing signs of severe stress. Management is working hard to cover-up the company’s precarious and rapidly deteriorating financial condition. However, with presales and condo prices now falling rapidly, with its income statement and assets materially overstated, and with its off-balance sheet guarantees looming as more and more imminent liabilities, our analysis suggests that the cover-up has entered its final inning.

Evergrande’s share price plunged following the report’s dissemination, and the company denied the accusations in a brief statement to the Hong Kong Stock Exchange on Thursday while reportedly considering legal action against Citron. A number of global investment houses published on the incident and questioned the validity of the report, with some even reiterating their “buy” rating on the stock, a fact that Evergrande hurried to point out in a stronger statement on Friday titled ““Eight Famous Investment Banks Support Evergrande to Dispel Rumors Spread by A Short Seller.” Reuters even reported that Evergrande had explored buying back some of its shares on the open market after the beating they took on Thursday, a move that aimed at further bolstering

Still, the damage was arguably done anyway. At a time when Chinese companies are suffering perhaps their greatest crisis of credibility in years, Evergrande joins a list of scandal-ridden companies that includes names such as Sino Forest, ChinaCast Education and SinoTech Energy. The difference is that the others were small and obscure companies while Evergrande ranked 5th in market capitalization among Chinese property names before the report. Sino Forest was a junior county-level cadre to Evergrande’s Politburo heavyweight.

Sino Forest, ChinaCast and SinoTech were, however, listed in the United States, where Patrick Chovanec writes that regulators may have to forcibly delist every Chinese company unless they can reach an agreement with China on a satisfactory way to deal with fraud investigations going forward. While such a “nuclear option” is unlikely, Chovanec writes that few investors or politicians have seriously considered the possibility:

Rather than assisting the SEC in its cross-border probes — as other countries regularly do — the China Securities Regulatory Commission (CSRC) has actively blocked the SEC’s information requests, insisting that audit materials on Chinese firms fall under China’s ambiguous yet draconian State Secrets Law. This April, when the SEC issued a subpoena to the Chinese arm of Deloitte, demanding the audit records of Longtop Financial (which collapsed last May after Deloitte resigned as its auditor), Deloitte refused, noting that the CSRC directly ordered them not to turn over such papers. The firm argued it could be dissolved and its partners jailed for life if they were to comply. In May, the SEC responded by initiating administrative proceedings to punish Deloitte China for violating its duties under the 2002 Sarbanes-Oxley Act. Penalties could include suspending the firm’s authority to perform audits for US-listed companies, which are required under U.S. securities laws. Apparently similar subpoenas have been issued to each of the other “Big Four” global audit firms (E&Y, KMPG, and PWC), and have met with similar replies.

There is a further complication. The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB), a five-person body appointed by the SEC. Public accounting firms that wish to perform audits on US-listed companies must register with PCAOB, and PCAOB is required, by law, to conduct inspections of those firms. So far, Chinese authorities have refused PCAOB permission to inspect auditors based in China, including the local arms of “Big Four” global audit firms. Last month, it looked like PCAOB might have worked out a compromise that would let it observe Chinese regulators perform their own inspection, but the SEC action against Deloitte China appears to have derailed that plan. The stage is set for a deadlock with serious, potentially disastrous implications, as my fellow CPA and Peking University counterpart Paul Gillis describes in his blog:

The PCAOB faces a December deadline to complete inspections of Chinese accounting firms that are registered with the PCAOB. It seems highly unlikely that they will meet this deadline, since Chinese regulators will not let them come to China. While the PCAOB could extend the deadline, they have already been under political pressure to act … Without resolution, the only meaningful option for the SEC, and the PCAOB, is for the PCAOB to deregister the firms and for the SEC to ban them from practice before the SEC.

The consequence of those actions would be that U.S. listed Chinese companies would be without auditors and unable to find them. Having an auditor is a listing requirement of the exchanges, so under exchange rules the companies face delisting. The U.S. listed Chinese companies would be unable to file financial statements as required. That should lead the SEC to eventually deregister the companies with the SEC.